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How Does The Generation-Skipping Tax Work?

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Everyone is taxed on what they “own” when they die. Wealthy families with smart attorneys were able to establish trusts for their children with assets that are subject to estate tax when parents die or to gift tax when the trusts were created but, because the trusts were carefully drafted, when the children (and future generations die) assets passed without being subject to the estate tax because those future generations were not treated as owning the assets for estate tax purposes.

This type of planning became known as “generation-skipping tax planning” (or “GST planning”).  In a way, that moniker is not entirely correct.  As discussed in greater detail below, in most generation-skipping tax plans parents don’t leave the assets directly to their grandchildren – skipping their children.  Rather, parents leave assets in trust for their children, remainder (when the children die) to their grandchildren.  The assets don’t skip the generation – only the tax does.

In 1986, Congress decided that allowing wealthy people to create trusts that weren’t subject to estate tax as assets passed from generation-to-generation was not a public policy that was worthy of support.  As a result, Congress created the GST.  The purpose was to turn assets not “owned” for estate tax purposes into assets deemed “owned” for GST purposes – and therefore, those assets would be subject to a transfer tax (the GST tax, not the estate tax) as they passed from children to grandchildren and future generations.  The GST tax rate is the highest estate tax rate.

When Congress enacted the GST, each person was allowed an amount that could still be passed down without being subject to the GST.  That amount is called the “GST exemption”.  It is, under current law, $11,580,000 – the same amount as the unified credit.  Yet people confuse the GST exemption with the unified credit.  An easy way to remember the difference is that the unified credit avoids transfer (estate) tax when someone dies and assets pass to their children.  The GST exemption avoids transfer (GST) tax when the children die and assets left in trust for them pass to their children.

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